Bank of Japan: limits to QE?

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Economic prospects have become more uncertain since the beginning of the year. Will the Federal Reserve be more aggressive faced with a US economy operating at full cruising speed? Does the flattening of the yield curve foreshadow a more-severe-than-expected slowdown in 2019? What will be the consequences of higher tariffs? These ambiguities have emerged at the same time as various pressures in the emerging countries.

Growth assumptions for the world economy remain at a high level in 2018 underpinned by a powerful combination of job creation, rising company profits and easy access to financing. Yet sources of concern have multiplied and others have become far more intense, leading to a sentiment of increased uncertainty. This is predominantly related to politics and economic policy, which leaves room for positive surprises, but if nothing changes, it could also result in ever stronger headwinds for consumer spending, business investment and international trade

The flattening of the US treasury curve has received a lot of attention as of late because historically recessions have been preceded by an inversion of the yield curve. A rather flat curve does not imply that a recession is imminent. However, historically once the yield curve starts to steepen after having flattened or inverted, a recession follows quite soon thereafter. Rather than focussing on the slope of the curve, one should wonder when the Fed will stop tightening.

Speculative positioning in VIX futures shows investors expect volatility to remain low, which implies an absence of growth or inflation shocks. The flattening of the US yield curve shows investors expect slower growth. These conflicting views may reflect differences in investment horizon but in the end, only one of the two can get it right, which is a source of concern.

Since the beginning of the year the financial markets and the global economy have reacted to various sources which is inherent, at least in part, in a market economy. We must constantly ask ourselves where the next bit of bad news might spring from, and also keep in mind that better visibility in one area is a reminder to search for other sources of uncertainty elsewhere.

Uncertainty has a big impact on the behaviour of households and companies. Unexpected events and their second round effects imply that to some extent it is unavoidable. Economic policy should avoid increasing it further. Whereas monetary policy aims to keep a lid on uncertainty, protectionist measures amplify it and can end up acting as a major headwind to growth.

German business climate indicators have eased since the start of the year, a movement which is broad-based. Very recently, some indicators have stabilised. Corporate uncertainty, as measured by the dispersion of the assessments of the economic outlook, has not increased yet despite concern about a trade war. However, dispersion tends to lag the overall evolution of the business climate so this indicator will need to be monitored closely in the coming months.

Worries about tariff increases are a headwind to growth because of the uncertainty about the outcome and its timing. Global value chains complicate the analysis. Tariffs increase input prices in the importing country and weigh on order books in the exporting country. Since the start of the year, both input prices and export orders have weakened in many countries. It’s probably too early to look for a link with tariff measures and tariff uncertainty.

Skilful expectations management meant that the announcement of the end of the net purchases of the QE program didn’t cause any stirs. Markets have applauded the introduction of date and state dependent guidance. In the course of next year, nervousness will increase again as investors will wonder whether conditions are met to warrant a first rate hike in this cycle.

High international correlations of markets can reflect the existence of global shocks, global swings in risk aversion or contagion. Contagion can be caused by a wide variety of factors. Taking into account the nature of the contagion is important when assessing its economic consequences.

Recent economic data in the US on the whole have been particularly strong. The labour market numbers released at the beginning of June surprised to the upside with strong job creation. Both the ISM manufacturing and non-manufacturing indices increased further and also beat expectations.

Political uncertainty in Italy has caused market turmoil with significant spillover effects within but also beyond the Eurozone. Contagion within the eurozone was of a different nature than in 2011. With a new government in place, attention will now focus on its economic policy, in particular in terms of public finances.

The ECB meeting account shows a central bank which is confident about the growth outlook despite the recent softness of data. The concerns relate to global factors which have become more prominent: the threat of trade protectionism. This concern is also echoed by the Federal Reserve.

Ever since the referendum of June 2016, when the UK has been grabbing headlines in the international press, it has been because of Brexit and its consequences. One would almost forget that the economy has been doing rather well actually, in particular given that uncertainty about Brexit has not yet been lifted.

In recent years, emerging market issuers, in particular corporates, have raised huge amounts of USD debt, thereby increasing their sensitivity to an appreciation of the dollar. Rising US treasury yields, a sudden strengthening of the dollar and country-specific issues have triggered considerable portfolio outflows and a weakening of emerging currencies.